Bankers Should Take A Lesson From The Mob

OP-ED

LIBOR Scandal: Bankers must restore confidence, as the mob did with numbers

August 03, 2012|By RICHARD S. GROSSMAN | OTHER OPINION

Recent revelations about the London Interbank Offered Rate (LIBOR) suggest a parallel with a once-popular form of gambling in America: the numbers racket. And fixing the defects in LIBOR may be as simple as it was to fix the numbers racket.

Before it was replaced by state lotteries, the numbers racket was a staple of American criminal activity. To play, you bet that some number between 0 and 999 would come up a winner. Originally, the winning number was determined by the spin of a wheel — typically by the gang running the numbers game.

When players began to suspect that the wheel was fixed, they stopped playing. After all, if no one bet on the number 123, the gang's payoff rose substantially if the winning number just happened to be 123. In order to restore faith, the method of choosing the winning number was changed into something that was easy to verify and less susceptible to being fixed. A common choice was the last three digits of the U.S. Treasury's daily balance, which was not likely to be fixed and was published in the newspaper and therefore could be verified by everybody.

LIBOR is supposed to measure bank borrowing costs — that is, the interest rates banks charge each other to borrow money. It is calculated by asking a handful of large banks how much they estimate it would cost them to borrow funds. The highest and lowest 25 percent of submitted estimates are thrown out; the average of the remainder is LIBOR.

LIBOR plays a vital role in the world financial system because it serves as a benchmark for some $800 trillion in securities transactions—everything ranging from complex derivatives to simple home mortgages. Because so much money is riding on LIBOR, traders have an incentive to pressure their banks into altering submission estimates to improve their profitability. Even a small movement in LIBOR could lead to millions in extra profits — or losses — for banks.

It has also been alleged that the British authorities encouraged banks to lower their submissions in the wake of the Lehman Brothers bankruptcy in 2008 to give the impression that banks had access to plentiful and cheap funds and were therefore less vulnerable to the crisis than they actually were.

The problem with LIBOR as currently constructed is that the incentive to cheat is enormous. The same can be said for virtually any aspect of finance that involves bankers monitoring their own behavior.

In theory, the government could require that banks report each and every transaction to regulators, who could then publish an average cost of funds index. This would be both cumbersome and unlikely to generate the new benchmark in a timely manner. Further, this method would be vulnerable to the same type of cheating that has plagued LIBOR.

Restoring confidence in LIBOR is as simple as it was to restore confidence in the numbers racket.

Instead of asking bankers for their best or worst estimates, the world's leading benchmark interest rate ought to be based on a market-determined figure. The recently launched GCF Repo index, published by the Depository Trust & Clearing Corp., might make a suitable substitute, although others are certainly possible.

The benefit of such an index is that it is determined by a large number of actual trades. Fully 2,600 GCF Repo index contracts were transacted on its first trading day. A market-determined figure will better reflect the availability and price of funds than the estimates of a dozen or so people who may have a financial interest in fiddling with the outcome to help their bottom line.

The LIBOR scandal has already cost Barclays a $450 million fine and is likely to lead to years of litigation brought by those who believe that the LIBOR price-fixing has cost them money.

In order to restore the world's benchmark interest rate, the financial system ought to take a lesson from the mob.

Richard S. Grossman is professor of economics at Wesleyan University and a visiting scholar at the Institute for Quantitative Social Science at Harvard University. He is the author of "Unsettled Account: The Evolution of Commercial Banking in the Industrialized World Since 1800."